Paying yourself whatever the company can afford: What the Companies Act actually requires for director remuneration

Your co-founder takes a ₹1.2 crore salary the year the company turns profitable. The board approved it over WhatsApp, no resolution was filed, and the CA deducted TDS every month. Two years later, the Assessing Officer disallows ₹40 lakh of it as "excessive" under Section 40A(2), and the ROC asks why there is no board resolution on record. Both objections are valid — and they come from two different laws that most founders assume are the same thing.

Director remuneration is governed twice over: the Companies Act 2013 decides whether the payment is validly authorised, and the Income Tax Act 1961 decides whether it is deductible. Clearing one does not clear the other. This is the approval-vs-deductibility conflict, and it catches profitable private companies more often than any other payroll issue.

What the law actually requires

Companies Act 2013: the authorisation layer

Section 197 caps managerial remuneration for public companies at 11% of net profits (calculated under Section 198), with sub-limits of 5% for one managing director/whole-time director and 10% for all of them together. Where profits are inadequate or nil, Schedule V Part II applies, permitting remuneration on a slab basis linked to effective capital — from ₹60 lakh per annum (effective capital under ₹5 crore) up to ₹24 crore plus 0.01% of effective capital above ₹250 crore, and double those limits with a special resolution.

Private companies are exempt from Section 197's ceilings. This is the exemption founders over-read. Exemption from the cap is not exemption from authorisation. Even in a private company:

• Remuneration to a director must be authorised by the articles of association or a board resolution, and by an ordinary resolution of shareholders if the articles so require (Section 197(4) principle, applied through the articles).
• Appointment of a managing director or whole-time director requires a board resolution followed by filing Form MGT-14 (for public companies under Section 117(3)(c)) and Form DIR-12 within 30 days of appointment. Private companies are exempt from MGT-14 for board resolutions under the 5 June 2015 exemption notification, but DIR-12 still applies to MD/WTD appointments.
• Section 188(1)(f) treats a related party's appointment to any "office or place of profit" above ₹2.5 lakh per month as a related party transaction needing board approval — and prior shareholder approval by ordinary resolution if the threshold in Rule 15 of the Companies (Meetings of Board and its Powers) Rules 2014 is crossed. A director's relative on the payroll at ₹3 lakh/month without this approval is a Section 188 violation, voidable at the option of the board, with the director liable to refund.
• Section 185 — remuneration cannot be dressed up as a loan. Advances against future salary beyond what is due are scrutinised as loans to directors.
• Sitting fees are separately capped at ₹1 lakh per meeting under Rule 4 of the Companies (Appointment and Remuneration of Managerial Personnel) Rules 2014.

Disclosure follows authorisation: aggregate remuneration appears in the financial statements (Schedule III), in MGT-7/MGT-7A, and related party remuneration in AOC-2 annexed to the board's report where applicable.

Income Tax Act 1961: the deductibility layer

The company deducts director salary as a business expense under Section 37(1) — but three provisions can undo it:

• Section 40A(2)(a): payments to specified persons (directors, their relatives, entities they substantially hold) can be disallowed to the extent the AO considers them excessive or unreasonable relative to the fair market value of services. There is no bright-line number; the AO benchmarks against comparable roles, company turnover, and the director's actual functions. A ₹1.2 crore salary in a ₹4 crore turnover company invites this test.
• Section 36(1)(ii): commission or bonus paid to a shareholder-director is disallowed if it would otherwise have been payable to them as dividend. Paying a 40% "performance bonus" to two founder-shareholders in proportion to their shareholding is the classic trigger.
• Section 2(22)(e): if a shareholder holding 10%+ draws money from the company beyond salary actually due — a running current account, ad-hoc withdrawals — the amount is taxed as deemed dividend in the director's hands, to the extent of accumulated profits. No corresponding deduction for the company.

On the director's side, remuneration to a whole-time/managing director is salary (TDS under Section 192, slab rates); fees to a non-executive director are professional income (TDS under Section 194J at 10%, and GST under reverse charge applies to the company on such fees per Notification 13/2017-Central Tax (Rate)).

Where the two statutes collide

The conflict is structural. The Companies Act asks: was this payment approved by the right organ, in the right form, and filed? The Income Tax Act asks: is this payment commercially justified? Four collision patterns:

• Approved but excessive: a properly resolved ₹2 crore salary can still be partly disallowed under Section 40A(2). Board approval is evidence of authorisation, not of reasonableness.
• Reasonable but unapproved: a modest salary with no board resolution is deductible in principle but leaves the company exposed on the Companies Act side — and an AO who spots the missing resolution will question whether the liability had crystallised in the year claimed.
• Waived limits, unwaived tax: a public company that exceeds Schedule V limits without the required special resolution must recover the excess from the director (Section 197(9)–(10)); until recovered, the director holds it in trust. The company cannot deduct an amount it is legally required to claw back.
• Dividend dressed as bonus: valid under company law, disallowed under Section 36(1)(ii).

Practical implications

• Section 197(15): contravention of Section 197 attracts a penalty of ₹1 lakh on the defaulting director and ₹5 lakh on the company (post-2020 decriminalisation, adjudicated by the ROC under Section 454 through MCA21 v3's e-adjudication module — notices now issue electronically and sit on the company's V3 dashboard).
• Section 188(5): an unapproved office-of-profit arrangement exposes the director to a penalty of ₹25 lakh (listed companies: also possible action under LODR) and the contract is voidable; the director must indemnify the company for any loss.
• Tax disallowance compounds: a ₹40 lakh disallowance under Section 40A(2) at the 25.17% effective rate (Section 115BAA) means roughly ₹10 lakh in tax plus interest under Sections 234B/234C, and potential penalty at 50% of tax on under-reported income under Section 270A.
• Deemed dividend is double pain: the director pays slab-rate tax on the deemed dividend with no deduction to the company, and the "salary" characterisation for the same money can be reopened.
• MCA21 v3 flags: DIR-12 filings, MGT-7A remuneration disclosures, and financial statement data are cross-indexed in V3. A whole-time director drawing remuneration with no DIR-12 on record is a data mismatch the system can surface during any other filing's scrutiny.
• Due diligence damage: in a funding round, missing remuneration resolutions are a standard legal DD red flag, usually resolved by ratification resolutions and, occasionally, price-chipping.

Step-by-step: what to do

• Paper the appointment. Pass a board resolution appointing the MD/WTD and fixing remuneration (salary, perquisites, bonus formula). File DIR-12 within 30 days. Public companies: also file MGT-14 within 30 days.
• Check your articles. If the AOA requires shareholder approval for director remuneration, pass an ordinary resolution at a general meeting. If your AOA is silent, amend it or take shareholder approval anyway — it costs one EGM and removes the argument.
• Run the Section 188 test for relatives. Any director's relative earning above ₹2.5 lakh/month needs prior board (and where applicable shareholder) approval as an office-of-profit RPT. Document arm's-length justification.
• Benchmark the number. Keep a one-page file note comparing the remuneration against industry norms, company turnover, and the director's role. This is your Section 40A(2) defence — created contemporaneously, not during assessment.
• Structure bonuses away from shareholding. Link any commission/bonus to measurable performance (revenue, EBITDA), not to shareholding proportions, to stay clear of Section 36(1)(ii).
• Kill the running current account. No ad-hoc withdrawals by 10%+ shareholder-directors. Pay salary monthly as resolved; anything extra goes through a fresh resolution — or Section 2(22)(e) applies.
• Get TDS and GST right. Executive directors: TDS under Section 192. Non-executive fees: TDS under Section 194J and RCM GST at 18% paid by the company.
• Disclose consistently. Same remuneration figure in Form 16, books, MGT-7A, and the board's report. Mismatches are what trigger both ROC and AO attention.
• Ratify past gaps now. If historical remuneration lacks resolutions, pass ratification resolutions at the next board and general meeting before a diligence exercise or scrutiny finds the gap first.

FAQ

Q1. My company is a private limited — do Section 197 limits apply to me at all?
No, the 11% ceiling and Schedule V slabs do not apply to private companies. But authorisation still does: you need a board resolution (and shareholder approval if your articles require it), DIR-12 for MD/WTD appointments, and Section 188 approval for relatives above ₹2.5 lakh/month.

Q2. Can the AO disallow a salary the shareholders unanimously approved?
Yes. Section 40A(2) reasonableness is tested against fair market value of services, not against corporate approvals. Unanimous shareholder approval helps as evidence but does not bind the AO.

Q3. Is remuneration to a non-executive director salary or professional fees?
Professional fees. TDS applies under Section 194J at 10%, and the company must pay GST at 18% under reverse charge. Only whole-time/managing directors in an employment relationship are on Section 192 salary TDS.

Q4. What happens if a public company paid beyond Schedule V limits without a special resolution?
Under Section 197(9)-(10), the director must refund the excess and holds it in trust for the company until repaid; waiver of recovery itself needs shareholder approval. Penalties under Section 197(15) — ₹1 lakh per director, ₹5 lakh for the company — can follow via ROC adjudication.

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Director remuneration is only "simple" until the first tax scrutiny or funding-round diligence. Approve it correctly under the Companies Act, benchmark it defensibly for the Income Tax Act, and keep the paper trail aligned across both.

For a compliance audit of your company, visit pvtltd.co.

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